Envelope Theorem

Kevin Wainwright
Mar 22, 2004

1 Maximum Value Functions

A maximum (or minimum) value function is an objective function where the choice
variables have been assigned their optimal values. These optimal values of the choice
variables are, in turn, functions of the exogenous variables and parameters of the
problem. Once the optimal values of the choice variables have been substituted into
the original objective function, the function indirectly becomes a function of the
parameters (through the parameters’ influence on the optmal values of the choice
variables). Thus the maximum value function is also referred to as the indirect
objective function.
What is the significance of the indirect objective function? Consider that in any
optimization problem the direct objective function is maximized (or minimized) for a
given set of parameters. The indirect objective function gives all the maximum values
of the objective function as these prameters vary. Hence the indirect objective func-
tion is an ”envelope” of the set of optimized objective functions generated by varying
the parameters of the model. For most students of economics the first illustration
of this notion of an ”envelope” arises in the comparison of short-run and long-run
cost curves. Students are typically taught that the long-run average cost curve is an
envelope of all the short-run average cost curves (what parameter is varying along
the envelope in this case?). A formal derivation of this concept is one of the exercises
we will be considering in the following sections.
To illustrate, consider the following maximization problem with two choice vari-
ables x and y, and one parameter, α:
Maximize
U = f (x, y, α) (1)
The first order necessary condition are

fx (x, y, α) = fy (x, y, α) = 0 (2)

if second-order conditions are met, these two equations implicitly define the solutions

x = x∗ (α) y = x∗ (α) (3)

1
If we subtitute these solutions into the objective function, we obtain a new function

V (α) = f (x∗ (α), y ∗ (α), α) (4)

where this function is the value of f when the values of x and y are those that
maximize f (x, y, α). Therefore, V (α) is the maximum value function (or indirect
objective function). If we differentiate V with respect to α
∂V ∂x∗ ∂y ∗
= fx + fy + fα (5)
∂α ∂α ∂α
However, from the first order conditions we know fx = fy = 0. Therefore, the
first two terms disappear and the result becomes
∂V
= fα (6)
∂α
This result says that, at the optimum, as α varies, with x∗ and y ∗ allowed to
adjust optimally gives the same result as if x∗ and y ∗ were held constant! Note that
α enters maximum value function (equation 4) in three places: one direct and two
indirect (through x∗ and y ∗ ). Equations 5 and 6 show that, at the optimimum, only
the direct effect of α on the objective function matters. This is the essence of the
envelope theorem. The envelope theorem says only the direct effects of a change in
an exogenous variable need be considered, even though the exogenous variable may
enter the maximum value function indirectly as part of the solution to the endogenous
choice variables.

1.1 The Profit Function

Let’s apply the above approach to an economic application, namely the profit function
of a competitive firm. Consider the case where a firm uses two inputs: capital, K,
and labour, L. The profit function is

π = pf (K, L) − wL − rK (7)

where p is the output price and w and r are the wage rate and rental rate respec-
tively.
The first order conditions are
π L = fL (K, L) − w = 0
(8)
π K = fK (K, L) − r = 0

which respectively define the factor demand equations

L = L∗ (w, r, p)
(9)
K = K ∗ (w, r, p)

2
 substituting the solutions K ∗ and L∗ into the objective function gives us

π∗ (w, r, p) = pf (K ∗ , L∗ ) − wL∗ − rK ∗ (10)

π∗ (w, r, p) is the profit function (or indirect objective function). The profit func-
tion gives the maximum profit as a function of the exogenous variables w, r, and
p.
Now consider the effect of a change in w on the firm’s profits. If we differentiate
the original profit function (equation 7) with respect to w, holding all other variables
constant and we get
∂π
= −L (11)
∂w
However, this result does not take into account the profit maximizing firms abil-
ity to make a substitution of capital for labour and adjust the level of output in
accordance with profit maximizing behavior.
Since π∗ (w, r, p) is the maximum value of profits for any values of w, r, and
p, changes in π ∗ from a change in w takes all captial for labour subsitutions into
account. To evaluate a change in the maximum profit function from a change in w,
we differentiate π∗ (w, r, p) with respect to w yielding

∂π ∗ ∂L∗ ∂K ∗
= [pfL − w] + [pfK − r] − L∗ (12)
∂w ∂w ∂w
From the first order conditions, the two bracketed terms are equal to zero. There-
fore, the resulting equation becomes
∂π ∗
= −L∗ (w, r, p) (13)
∂w
This result says that, at the the profit maximizing position, a change in profits with
respect to a change in the wage is the same whether or not the factors are held constant
or allowed to vary as the factor price changes. In this case the derivative of the profit
function with respect to w is the negative of the factor demand function L∗ (w, r, p).
Following the above procedure, we can also show the additional comparative statics
results
∂π ∗ (w, r, p)
= −K ∗ (r, w, p) (14)
∂r
and
∂π ∗ (w, r, p)
= f (K ∗ , L∗ ) = q∗ (15)
∂p
The simple comparative static results derived from the profit function is known
as ”Hotelling’s Lemma”. Hotelling’s Lemma is simply an application of the envelope
theorem.

3
1.2 The Envelope Theorem and Constrained Optimization
Now let us turn our attention to the case of constrained optimization. Again we will
have an objective function (U), two choice variables, (x and y) and one prarameter
(α) except now we introduce the following constraint:

g(x, y; α) = 0

The derivation of the envelope theorem for the models with one constraint is as
follows:
The problem then becomes
Maximize
U = f (x, y; α) (16)
subject to
g(x, y; α) = 0 (17)
The Lagrangian for this problem is

Z = f (x, y; α) + λg(x, y; α) (18)

The first order conditions are

Zx = fx + λgx = 0
Zy = fy + λgy = 0 (19)
Zλ = g(x, y; α) = 0

Solving this system of equations gives us

x = x∗ (α) y = y ∗ (α) λ = λ∗ (α) (20)

Substituting the solutions into the objective function, we get

U ∗ = f (x∗ (α), y ∗ (α), α) = V (α) (21)

where V (α) is the indirect objective function, or maximum value function. This
is the maximum value of y for any α and xi ’s that satisfy the constraint.

How does V (α) change as α changes? First, we differentiate V with respect to α

∂V ∂x∗ ∂y ∗
= fx + fy + fα (22)
∂α ∂α ∂α
In this case,equation 22 will not simplify to ∂V ∂α
= fα since fx 6= 0 and fy 6= 0.
However, if we substitute the solutions to x and y into the constraint (producing an
identity)
g(x∗ (α), y ∗ (α), α) ≡ 0 (23)

4
and differentiating with respect to α yields
∂x∗ ∂x∗
gx + gx + gα ≡ 0 (24)
∂α ∂α
If we multiply equation 24 by λ and combine the result with equation 22 and
rearranging terms, we get
∂V ∂x∗ ∂y ∗
= (fx + λgx ) + (fy + λgy ) + fα + λgα = Zα (25)
∂α ∂α ∂α
Where Zα is the partial deviative of the Lagrangian function with respect to α,
holding all other variable constant. In this case, the Langrangian functions serves as
the objective function in deriving the indirect objective function.
While the results in equation 25 nicely parallel the unconstrained case, it is impor-
tant to note that some of the comparative static results depend critically on whether
the parameters enter only the objective function or whether they enter only the con-
straints, or enter both. If a parameter enters only in the objective function then the
comparative static results are the same as for unconstrained case. However, if the
parameter enters the constraint, the relation

Vαα ≥ fαα

will no longer hold.

1.3 Interpretation of the Lagrange Multiplier

In the consumer choice problem in chapter 12 we derived the result that the Lagrange
multiplier, λ, represented the change in the value of the Lagrange function when
the consumer’s budget changed. We loosely interpreted λ as the marginal utility of
income. Now let us derive a more general interpretation of the Lagrange multiplier
with the assistance of the envelope theorem.Consider the problem
Maximize
U = f (x, y) (26)
Subject to
c − g(x, y) = 0 (27)
where c is a constant. The Lagrangian for this problem is

Z = f (x, y) + λ(c − g(x, y)) (28)

The first order equations are

Zx = fx (x, y) − λgx (x, y) = 0

Zy = fy (x, y) − λgy (x, y) = 0 (29)
Zλ = c − g(x, y) = 0

5
 From the firs twot equations in (29), we get

fx fy
λ= = (30)
gx gy

which gives us the condition that the slope of the level curve of the objective function
must equal the slope of the constraint at the optimum.
Equations (29) implicitly define the solutions

x = x∗ (c) y = y(c) λ = λ∗ (c) (31)

substituting (31) back into the Lagrangian yields the mamximum value function

V (c) = Z ∗ (c) = f (x∗ (c), y ∗ (c)) + λ∗ (c) (c − g(x∗1 (c), y ∗ (c))) (32)

differentiating with respect to c yields

∂Z ∗ ∂x∗ ∂y ∗ ∂λ∗ ∂x∗ ∂y ∗ ∂c

= fx +fy ∗ ∗
+(c − g(x (c), y (c))) −λ∗ (c)gx −λ∗ (c)gy +λ∗ (c)
∂c ∂c ∂c ∂c ∂c ∂c ∂c
(33)
by rearranging we get

∂Z ∗ ∂x∗ ∂y ∗ ∂λ∗
= (fx − λ∗ gx ) + (fy − λ∗ gy ) + (c − g(x∗ , y ∗ )) + λ∗ (34)
∂c ∂c ∂c ∂c
Note that the three terms in brackets are nothing more than the first order equa-
tions and, at the optimal values of x, y and λ, these terms are all equal to zero.
Therefore this expression simplifies to

∂V (c) ∂Z ∗
= = λ∗ (35)
∂c ∂c
Therefore equals the rate of change of the maximum value of the objective function
when c changes (λ is sometimes referred to as the ”shadow price” of c).Note that, in
this case, c enters the problem only through the constraint; it is not an argument of
the original objective function.

2 Duality and the Envelope Theorem

A consumer’s expenditure function and his indirect utility function are the minimum
and maximum value functions for dual problems. An expenditure function specifies
the minimum expenditure required to obtain a fixed level of utility given the utility
function and the prices of consumption goods. An indirect utility function speci-
fies the maximum utility that can be obtained given prices, income and the utility
function.

6
 Let U(x, y) be a utility function in x and y are consumption goods. The consumer
has a budget, B, and faces market prices Px and Py for goods x and y respectively.
Setting up the Lagrangian:

Z = U(x, y) + λ(B − Px x − Py y) (36)

The first order conditions are

Zx = Ux − λPx = 0
Zy = Uy − λPy = 0 (37)
Zλ = B − Px X − Py Y = 0

This system of equations implicity defines a solution for xM , y M and λM as a

function of the exogenous variables B, Px , Py .

xM = xM (Px , Py , B)
y M = y M (Px , Py , B) (38)
λM = λM (Px , Py , B, α)

The solutions to xM and y M are the consumer’s ordinary demand functions, some-
times called the ”Marshallian” demand functions.1
Substituting the solutions to x∗ and y ∗ into the utility function yields

U ∗ = U ∗ (xM (B, Px , Py ), y M (B, Px , Py )) = V (B, Px , Py ) (39)

Where V is the maximum value function, or indirect utility function.

Now consider the alternative, or dual, problem for the consumer; minimize total
expenditure on x and y while maintaining a given level of utility, U ∗ . The Langranian
for this problem is
Z = Px x + Py y + λ(U ∗ − U(x, y)) (40)
The first order conditions are
Zx = Px − λUx = 0
Zy = Py − λUy = 0 (41)
Zλ = U ∗ − U(x, y; α) = 0

This system of equations implicitly define the solutions to xh , y h and λh

xh = xh (U ∗ , Px , Py )
y h = y h (U ∗ , Px , Py ) (42)
λh = λh (U ∗ , Px , Py )
1
Named after the famous economist Alfred Marshall, known to most economic students as ”an-
other dead guy.”

7
 xh and y h are the compensated, or ”real income” held constant demand func-
tions. They are commonly referred to as ”Hicksion” demand functions, hence the h
superscript.2
If we compare the first two equations from the first order conditions in both utility
maximization problem and expenditure minimization problem (Zx , Zy ), we see that
both sets can be combined (eliminating λ) to give us
Px Ux
= (= MRS) (43)
Py Uy
This is the tangency condition in which the consumer chooses the optimal bundle
where the slope of the indifference curve equals the slope of the budget constraint.
The tangency condition is identical for both problems. If the target level of utility
in the minimization problem is set equal to the value of the utility obtained in the
solution to the maximization problem, namely U ∗ , we obtain the following
xM (B, Px , Py ) = xh (U ∗ , Px , Py )
(44)
y M (B, Px , Py ) = y h (U ∗ , Px , Py )
or the solution to both the maximization problelm and the minimization problem
produce identical values for x and y. However, the solutions are functions of different
exogenous variables so any comparative statics exercises will produce different results.
Substituting xh and y h into the objective function of the minimization problem
yields
Px xh (Px , Py , U ∗ ) + Py y h (Px , Py , U ∗ ) = E(Px , Py , U ∗ ) (45)
where E is the minimum value function or expenditure function. The duality
relationship in this case is
E(Px , Py , U ∗ , α) = B (46)
where B is the exogenous budget from the maximization problem.
Finally, it can be shown from the first order conditions of the two problems that
1
λM = (47)
λh

2.1 Roy’s Identity

One application of the envelope theorem is the derivation of Roy’s identity. Roy’s
identity states that the individual consumer’s marshallian demand function is equal
to the ratio of partial derviatives of the maximum value function. Substituting the
optimal values of xM , y M and λM into the Lagrangian gives us

V (B, Px , Py ) = U(xM , y M ) + λM (B − Px xM − Py y M ) (48)

2
Yet another famous, but dead economist, Sir John Hicks.

8
 First differentiate with respect to Px

∂V ∂xM ∂y M ∂λM
= (Ux −λM Px ) +(Uy −λM Py ) +(B −Px xM −Py y M ) −λM xM (49)
∂Px ∂Px ∂Px ∂Px

∂V ∂xM ∂y M ∂λM
= (0) + (0) + (0) − λM xM = −λM xM (50)
∂Px ∂Px ∂Px ∂Px
Next, differentiate the value function with respect to B
M
∂V M ∂xM M ∂y M M ∂λ
= (Ux − λ Px ) + (Uy − λ Py ) M
+ B − Px x − Py y ) + λM (51)
∂B ∂B ∂B ∂B

∂V ∂xM ∂y M ∂λM
= (0) + (0) + (0) + λM = λM (52)
∂B ∂B ∂B ∂B
Finally, taking the ratio of the two partial derivatives
∂V
∂Px −λM xM
= = xM (53)
∂V
∂B λM

which is Roy’s identity.

2.2 Shephard’s Lemma

Earlier in the chapter an application of the envelope theorem was the derivation
of Hotelling’s Lemma, which states that the partial derivatives of the maximum
value of the profit function yields the firm’s factory demand functions and the supply
functions. A similar approach applied to the expenditure function yields Shepard’s
Lemma.
Consider the consumer’s minimization problem. The Lagrangian is

Z = Px x + Py y + λ(U ∗ − U(x, y)) (54)

From the first order conditions, the solutions are implicitly defined

xh = xh (Px , Py , U ∗ )
y h = y h (Px , Py , U ∗ ) (55)
λh = λh (Px , Py , U ∗ )

Substituting these solutions into the Lagrangian yields the minimum value func-
tion
V (Px , Py , U ∗ ) = Px xh + Py y h + λh (U ∗ − U(xh , y h )) (56)

9
 The partial derivatives of the value function with respect to Px and Py are the
consumer’s conditional, or Hicksian, demands:
h ∂y h h
∂V
∂Px
= (Px − λh Ux ) ∂P
∂x
+ (Py − λh Uy ) ∂P ∂λ
+ (U ∗ − U(xh , y h )) ∂P + xh
∂V ∂xh ∂y
x
h
∂λh
x x (57)
∂Px
= (0) ∂P x
+ (0) ∂P x
+ (0) ∂P x
+ xh = xh
and
h ∂y h h
∂V
∂Py
= (Px − λh Ux ) ∂P
∂x
+ (Py − λh Uy ) ∂P ∂λ
+ (U ∗ − U (xh , y h )) ∂P + yh
∂V ∂xh ∂y
y
h
∂λ h
y y
(58)
∂Py
= (0) ∂P y
+ (0) ∂P y
+ (0) ∂P y
+ yh = yh

Differentiating V with respect to the constraint U∗ yields λh , the marginal cost of

the constraint
h
∂V h ∂xh h ∂y h h h ∂λ
= (Px − λ Ux ) + (Py − λ Uy ) + (U ∗
− U(x , y )) + λh
∂U ∗ ∂U ∗ ∂Py ∂U ∗
∂V ∂xh ∂y h ∂λh
∗
= (0) ∗ + (0) ∗ + (0) ∗ + y h = λh
∂U ∂U ∂U ∂U
Together, these three partial derivatives are Shepard’s Lemma.

2.3 Example of duality for the consumer choice problem

2.3.1 Utility Maximization
Consider a consumer with the utility function U = xy, who faces a budget constraint
of B = Px xPy y, where all variables are defined as before.
The choice problem is
Maximize
U = xy (59)
Subject to
B = Px xPy y (60)
The Lagrangian for this problem is
Z = xy + λ(B − Px xPy y) (61)
The first order conditions are
Zx = y − λPx = 0
Zy = x − λPy = 0 (62)
Zλ = B − Px x − Py y = 0
Solving the first order conditions yield the following solutions
B B B
xM = 2Px
yM = 2Py
λ= 2Px Py (63)

10
 where xM and y M are the consumer’s Marshallian demand functions. Checking
second order conditions, the bordered Hessian is
¯ ¯
¯ 0 1 −P ¯
¯ ¯ ¯ x ¯
¯H ¯ = ¯ 1 0 −Py ¯¯ = 2Px Py > 0 (64)
¯
¯ −Px −Py 0 ¯

Therefore the solution does represent a maximum . Substituting xM and y M into

the utility function yields the indirect utility function
µ ¶µ ¶
B B B2
V (Px , Py , B) = = (65)
2Px 2Py 4Px Py

If we denote the maximum utility by U0 and re-arrange the indirect utility function
to isolate B
B2
= U0 (66)
4Px Py
1 1 1 1
B = (4Px Py U0 ) 2 = 2Px2 Py2 U02 = E(Px , Py , U0 ) (67)
We have the expenditure function

Roy’s Identity Let’s verify Roy’s identity which states

∂V
M ∂Px
x = − ∂V (68)
∂B

Taking the partial derivative of V

∂V B2
=− 2 (69)
∂Px 4Px Py
and
∂V B
=− (70)
∂B Px Py
Taking the negative of the ratio of these two partials
³ 2 ´
∂V B
∂Px 4Px2 Py B
− ∂V = − ³ ´ = = xM (71)
∂B
B 2Px
Px Py

Thus we find that Roy’s Identity does hold.

11
2.3.2 The dual and Shepard’s Lemma
Now consider the dual problem of cost minimization given a fixed level of utility.
Letting U0 denote the target level of utility, the problem is
Minimize
Px x + Py y (72)
Subject to
U0 = xy (73)
The Lagrangian for the problem is
Z = Px x + Py y + λ(U0 − xy) (74)
The first order conditions are
Zx = Px − λy = 0
Zy = Py − λx = 0 (75)
Zλ = U0 − xy = 0
Solving the system of equations for x, y and λ
³ ´ 12
xh = PPy Ux 0
³ ´1
h Px U0 2 (76)
y = Py
³ ´ 12
λh = PUx P0 y

where xh and y h are the consumer’s compensated (Hicksian) demand functions.

Checking the second order conditions for a minimum
¯ ¯
¯ 0 −λ −y ¯
¯ ¯ ¯ ¯
¯H ¯ = ¯ −λ 0 −x ¯ = −2xyλ < 0 (77)
¯ ¯
¯ −y −x 0 ¯

Thus the sufficient conditions for a minimum are satisfied.

Substituting xh and y h into the orginal objective function gives us the minimum
value function, or expenditure function
³ ´ 12 ³ ´ 12
Py U0 Px U0
Px xh + Py y h = Px Px
+ Py Py
1
= (Px Py U0 ) 2 + (Px Py U0 ) 2
1
(78)
1 1 1
2
= 2Px Py U0
2 2

Note that the expenditure function derived here is identical to the expenditure
function obtained by re-arranging the indirect utility function from the maximization
problem.

12
Shepard’s Lemma We can now test Shepard’s Lemma by differentiating the ex-
penditure function directly.
First, we derive the conditional demand functions
1 1
∂E(Px , Py , U0 ) ∂ ³ 12 12 12 ´ Py2 U02
= 2Px Py U0 = 1 = xh (79)
∂Px ∂Px Px 2

and 1 1
∂E(Px , Py , U0 ) ∂ ³ 12 12 12 ´ Py2 U02
= 2Px Py U0 = 1 = yh (80)
∂Py ∂Py Py 2

Next, we can find the marginal cost of utility (the Lagrange multiplier)
1 1
∂E(Px , Py , U0 ) ∂ ³ 12 12 12 ´ Px2 Py2
= 2Px Py U0 = 1 = λh (81)
∂U 0 ∂U 0 U0 2

Thus, Shepard’s Lemma holds in this example.

3 Income and Substitution Effects: The Slutsky

Equation
3.1 The Traditional Approach
Consider a representative consumer who chooses only two goods: x and y. The price
of both goods are determined in the market and are therefore exogenous. As well,
the consumer’s budget is also exogenously determined. The consumer choice problem
then is
Maximize
U(x, y) (82)
Subject to
B = Px X + Py Y (83)
The Langrangian function for this optimization problem is

Z = U (x, y) + λ(B − Px x + Py y) (84)

The first order conditions yield the following set of simultaneous equations:

Zλ = B − Px x − Py y = 0
Zx = Ux − λPx = 0 (85)
Zy = Uy − λPy = 0

13
 Solving this system will allow us to express the optimal values of the endogenous
variables as implicit functions of the exogenous variables:
λ∗ = λ∗ (Px , Py , B)
x∗ = x∗ (Px , Py , B)
y ∗ = y ∗ (Px , Py , B)
If the bordered Hessian in the present problem is positive
¯ ¯
¯ ¯
¯ ¯ ¯ 0 −Px −Py ¯
¯H ¯ = ¯ −Px Uxx Uxy ¯ = 2Px Py Uxy − Py2 Uxx − Px2 Uyy > 0 (86)
¯ ¯
¯ −Py Uyx Uyy ¯
then the value of U will be a maximum.
.
By substituting the optimal values x∗ , y ∗ and λ∗ into the first order equations, we
convert these equations into equilibrium identities:
B − Py x∗ − Py y ∗ ≡ 0
Ux (x∗ , y ∗ ) − λ∗ Px ≡ 0
Uy (x∗ , y ∗ ) − λ∗ Py ≡ 0
By taking the total differential of each identity in turn, and noting that Uxy = Uyx
(Young’s Theorem), we then arrive at the linear system
−P xdx∗ − P ydy = x∗ dP x + y ∗ dP y − dB
−P xdλ∗ + Uxx dx∗ + Uxy dy ∗ = λ∗ dP x (87)
−P ydλ∗ + Uyx dx∗ + Uyy dy ∗ = λ∗ dP y
Writing these equations in matrix form
  ∗   ∗ 
0 −Px −Py dλ x dPx + y ∗ dPy − dB
 −Px Uxx Uxy   dx∗  =  λ∗ dPx 
∗
−Py Uyx Uyy dy ∗ λ dPy
To study the effect of a change in the budget, let the other exogenous differentials
equal zero (dPx = dPy = 0, dB 6= 0). Then dividing through by dB, and applying the
implicit function theorem, we have
  ∗   
0 −Px −Py dλ /∂B −1
 −Px Uxx Uxy   dx∗ /∂B  =  0  (88)
−Py Uyx Uyy dy ∗ /∂B 0
The coefficient matrix of this
¯ ¯system is the Jacobian matrix, which has the same
value as the bordered Hessian ¯H ¯ which is positive if the second order conditions are
met. By using Cramer’s rule we can solve for the following comparative static
¯ ¯
¯ 0 −1 −Py ¯ ¯ ¯ ¯ ¯
∂x∗
1 ¯¯ ¯ 1 ¯ −Px Uxy ¯ ¯H̄12 ¯
= ¯ ¯ ¯ −Px 0 Uxy ¯¯ = ¯ ¯ ¯¯ ¯= ¯ ¯ ≶0 (89)
∂B ¯H ¯ ¯ ¯ ¯H ¯ −Py Uyy ¯ ¯H ¯
−Py 0 Uyy

14
 As before, in the absence of additional information about the relative magnitudes
of Px , Py and the cross partials, Uij , we are unable to ascertain the sign of this
comparative-static derivative. This means that the optimal x∗ may increase in the
budget, B, depending on whether it is a normal or inferior good (ambiguous income
effect)
Next, we may analyze the effect of a change in Px . Letting dPy = dB = 0 but
keeping dPx 6= 0 and dividing Equation 87 by dPx we obtain
    ∗ 
0 −Px −Py ∂λ∗ /∂Px x
 −Px Uxx Uxy   ∂x∗ /∂Px  =  λ∗  (90)
∗
−Py Uyx Uyy ∂y /∂Px 0

From this, the following comparative static emerges:

¯ ¯
¯ 0 x∗
−P ¯
¯ y ¯
∂x∗ 1 ¯
= H ¯ −Px λ Uxy ¯¯∗
∂Px | |¯ ¯
¯ −Py 0 U ¯ yy ¯ ¯
¯
−x∗ ¯ −Px Uxy ¯
¯ λ∗ ¯ 0 −Py ¯ (91)
= H ¯ + ¯ ¯
| | −Py Uyy ¯ |H | ¯ −Py Uyy ¯
|H̄12 | |H̄22 |
= (−x∗ ) H + λ∗ H
| | | |
∂x ∗
Note that there are two componants in ( ∂P x
). By comparing the first term to our
∂x ∗
previous comparative static ( ∂B ), we see that
¯ ¯ µ ∗¶
¯H̄12 ¯ ∂x
(−x )∗ ¯ ¯ ∗
= (−x ) ≶0 (92)
¯H ¯ ∂B

which can be interpreted as the income effect of a price change. The second term
is the income compensated version of ∂x∗ /∂Px , or the substitution effect of a price
change, which is unambiguously negative:
µ ∗¶ ¯ ¯ ¯ ¯
λ∗ ¯¯ 0 −Py ¯¯ ¯ ¯ λ∗
∂x ∗ H̄22
= ¯ ¯ ¯ ¯ =λ ¯ ¯ = ¯ ¯ (Py2 ) < 0 (93)
∂Px compensated ¯ H ¯ −Py U yy ¯ H ¯ ¯H¯
Hence, we can express Equation 91 in the form
µ ∗¶ µ ∗¶
∂x∗ ∂x ∗ ∂x
∗
=− x + (94)
∂P ∂B ∂Px compensated
| {z } | {z }
Income Effect Substitution Effect

This result, which decomposes the comparative static derivative (∂x∗ /∂Px ) into
two componants, an income effect and a substitution effect, is the two-good version
of the ”Slutsky Equation.”

15
3.2 Duality and the Alternative Slutsky
From the envelope theorem, we can derive the Slutsky decomposition in a more
succinct manner. Consider first that from the utility maximum problem we derived
solutions for x and y
xM = xM (Px , Py , B)
(95)
y M = y M (Px , Py , B)
which were the marshallian demand functions. Substituting these solutions into the
utility function yielded the indirect utility function (or maximum value function)

U ∗ = U(xM (Px , Py , B), y M (Px , Py , B)) = U ∗ (Px , Py , B) (96)

which could be rewritten to isolate B and giving us the expenditure function

B ∗ = B(Px , Py, U ∗ ) (97)

Second, from the budget minimization problem we derived the Hicksian, or com-
pensated, demand function
x∗ = xh (Px , Py, U ∗ ) (98)
which, by Shephards lemma, is equivalent to the partial derivative of the expenditure
function with respect to Px :
∂B(Px , Py, U ∗ )
= xc (Px , Py, U ∗ ) (99)
∂Px
Thus we know that if the maximum value of utility obtained from

Max U(x, y) + λ(B − Px x − Py y)

is the same value as the exogenous level of utility found in the constrained minimiza-
tion problem
Min Px x + Py y + λ(U0 − U(x, y)) (100)
the values of x and y that satisfy the first order conditions of both problems will
be identical, or
xc (Px , Py, U0 ) = xm (Px , Py, B) (101)
at the optimum.If we subsitiute the expenditure function into xM in place of the
budget, B, we get

xc (Px , Py, U0 ) = xM (Px , Py, B ∗ (Px , Py, U0 )) (102)

Differentiate both sides of equation 102 with respect to Px

∂xc (Px ,Py, U0 ) ∂xM (Px ,Py, B ∗ (Px ,Py, U0 ))
∂Px
= ∂Px
M B ∗ (Px ,Py, U0 )) ∂B(Px ,Py, U0 ) (103)
+ ∂x (Px ,Py,∂B ∂Px

16
 But we know from Shephard’s lemma that
∂B(Px , Py, U0 )
= xc (104)
∂Px
substituting equation 104 in to equation 103 we get
∂xc ∂xM ∂xM
= + xc (105)
∂Px ∂Px ∂B
M
Subtract (xc ∂x
∂B
) from both sides gives us
∂xM ∂xM ∂xc
= −xc + (106)
∂Px ∂B
| {z } ∂Px
|{z}
Income effect Substitution effect

If we compare equation (106) to equation (94) we see that we have arrived at the
identical result. The method of deriving the slutsky decomposition through the ap-
plication of duality and the envelope theorem is sometimes referred to as the ”instant
slutsky”.

3.2.1 Problems:
1. A consumer has the following utility function: U(x, y) = x(y +1), where x and y
are quantities of two consumption goods whose prices are px and py respectively.
The consumer also has a budget of B. Therefore the consumer’s maximization
problem is
x(y + 1) + λ(B − px x − py y)

(a) From the first order conditions find expressions for the demand functions.
What kind of good is y? In particular what happens when py > B/2?
(b) Verify that this is a maximum by checking the second order conditions.
By substituting x∗ and y ∗ into the utility function find an expressions for
the indirect utility function
U ∗ = U (px , py , B)
and derive an expression for the expenditure function
B ∗ = B(px , py , U ∗ )
(c) This problem could be recast as the following dual problem
Minimize px x + py y subject to U ∗ = x(y + 1)
Find the values of x and y that solve this minimization problem and show
that the values of x and y are equal to the partial derivatives of the ex-
penditure function, ∂B/∂px and ∂B/∂py respectively.

17